The document summarizes the dividend discount model valuation of several companies. For Con Edison, the model estimates a value of $42.37 per share based on an expected growth rate of 3%. For ABN Amro, a two-stage DDM is used with a high growth phase of 5 years at 9.73% followed by stable growth of 5%. This estimates a value of 30.87 Euros per share. For the S&P 500, a two-stage DDM estimates an intrinsic value of $526.35, significantly below the current level of 1320, indicating potential overvaluation.
This is the fourth presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at returns on different types of investment.
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
This presentation covers the basics of Dividend Discount Model (DDM). Firstly, fundamental formula for valuing a stock using DDM is discussed. After that, 3 cases i.e DDM for zero growth, constant growth, and variable growth stocks, are discussed.
This is the fourth presentation for the University of New England Graduate School of Business unit, GSB711 - Managerial Finance. This presentation looks at returns on different types of investment.
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
This presentation covers the basics of Dividend Discount Model (DDM). Firstly, fundamental formula for valuing a stock using DDM is discussed. After that, 3 cases i.e DDM for zero growth, constant growth, and variable growth stocks, are discussed.
Chapter 1 - Overview of Financial Statement Analysis
Solution Manual Wild
Financial Statement Analysis -
f i n a n c i a l
s tat e m e n t
a n a l y s i s
TENTH EDITION
K. R.
SUBRAMANYAM
JOHN J. WILD
Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.
Explain the general concept of opportunity cost of capital.
Distinguish between the project cost of capital and the firm’s cost of capital.
Learn about the methods of calculating component cost of capital and the weighted average cost of capital.
Understand the concept and calculation of the marginal cost of capital.
Recognise the need for calculating cost of capital for divisions.
Understand the methodology of determining the divisional beta and divisional cost of capital.
Illustrate the cost of capital calculation for a real company.
risk and return. Defining Return, Return Example, Defining Risk,Determining Expected Return , How to Determine the Expected Return and Standard Deviation, Determining Standard Deviation (Risk Measure), Portfolio Risk and Expected Return Example, Determining Portfolio Expected Return, Determining Portfolio Standard Deviation, Summary of the Portfolio Return and Risk Calculation, Total Risk = Systematic Risk + Unsystematic Risk,
Chapter 1 - Overview of Financial Statement Analysis
Solution Manual Wild
Financial Statement Analysis -
f i n a n c i a l
s tat e m e n t
a n a l y s i s
TENTH EDITION
K. R.
SUBRAMANYAM
JOHN J. WILD
Because of the risk-return tradeoff, you must be aware of your personal risk tolerance when choosing investments for your portfolio. Taking on some risk is the price of achieving returns; therefore, if you want to make money, you can't cut out all risk. The goal instead is to find an appropriate balance - one that generates some profit, but still allows you to sleep at night.
Explain the general concept of opportunity cost of capital.
Distinguish between the project cost of capital and the firm’s cost of capital.
Learn about the methods of calculating component cost of capital and the weighted average cost of capital.
Understand the concept and calculation of the marginal cost of capital.
Recognise the need for calculating cost of capital for divisions.
Understand the methodology of determining the divisional beta and divisional cost of capital.
Illustrate the cost of capital calculation for a real company.
risk and return. Defining Return, Return Example, Defining Risk,Determining Expected Return , How to Determine the Expected Return and Standard Deviation, Determining Standard Deviation (Risk Measure), Portfolio Risk and Expected Return Example, Determining Portfolio Expected Return, Determining Portfolio Standard Deviation, Summary of the Portfolio Return and Risk Calculation, Total Risk = Systematic Risk + Unsystematic Risk,
basic financial analysis, framework for ratio analysis, types of ratio analysis, liquidity ratios, debt ratios, equity ratios, activity ratios, profit ratio, index analysis, common size financial statements
Slide 1
7-1
Cash Flows for Stockholders
• If you own a share of stock, you can receive
cash in two ways
The company pays dividends
You sell your shares, either to another investor in
the market or back to the company
• As with bonds, the price of the stock is the
present value of these expected cash flows
Dividends → cash income
Selling → capital gains
In this module, we turn to the other major source of financing for corporations, common and preferred stock.
The goal of financial management is to maximize stock prices, so an understanding of what determines
share values is obviously a key concern. The dividends currently being paid are one of the primary factors
we look at when we attempt to value common stocks. This module explores dividends, stock values, and
the connection between the two.
A share of common stock is more difficult to value in practice than a bond, for at least three reasons.
First, with common stock, not even the promised cash flows are known in advance.
Second, the life of the investment is essentially forever, since common stock has no maturity.
Third, there is no way to easily observe the rate of return that the market requires.
However, we can come up with the present value of the future cash flows for a share of stock making some
assumptions.
Slide 2
7-2
One Period Example
• Suppose you are thinking of purchasing the
stock of Moore Oil, Inc.
– You expect it to pay a $2 dividend in one year
– You believe you can sell the stock for $14 at that
time.
– You require a return of 20% on investments of this
risk
– What is the maximum you would be willing to
pay?
Slide 3
7-3
One Period Example
• D1 = $2 dividend expected in one year
• R = 20%
• P1 = $14
• CF1 = $2 + $14 = $16
• Compute the PV of the expected cash flows
33.13$
20.1
)142(
P
0
Note, the calculation can also be done as:
FV = 14; PMT = 2; I/Y = 20; N = 1; CPT PV = -13.33
Slide 4
7-4
Two Period Example
• What if you decide to hold the stock for two years?
– In addition to the dividend in one year, you expect a
dividend of $2.10 in two years and a stock price of
$14.70 at the end of year 2.
– Now how much would you be willing to pay?
33.13$
)20.1(
)70.1410.2(
20.1
2
P
20
Calculator: CF0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I =
20; CPT NPV = 13.33
We can use uneven cash flow keys.
Slide 5
7-5
Three Period Example
• What if you decide to hold the stock for three
years?
– In addition to the dividends at the end of years 1 and 2,
you expect to receive a dividend of $2.205 at the end of
year 3 and the stock price is expected to be $15.435.
– Now how much would you be willing to pay?
33.13$
)20.1(
)435.15205.2(
)20.1(
10.2
20.1
2
P
320
Calcultator: CF0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64;
F03 = 1; NPV; I = 20; CPT NPV = 13.33
Slide 6
7-6
Devel.
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2. Aswath Damodaran 2
General Information
n The risk premium that I will be using in the 1999 and 2000 valuations
for mature equity markets is 4%. This is the average implied equity
risk premium from 1960 to 2000.
n For the valuations from 1998 and earlier, I use a risk premium of
5.5%.
3. Aswath Damodaran 3
Con Ed: Rationale for Model
n The firm is in stable growth; based upon size and the area that it
serves. Its rates are also regulated; It is unlikely that the regulators will
allow profits to grow at extraordinary rates.
n Firm Characteristics are consistent with stable, DDM model firm
• The beta is 0.80 and has been stable over time.
• The firm is in stable leverage.
• The firm pays out dividends that are roughly equal to FCFE.
– Average Annual FCFE between 1994 and 1999 = $553 million
– Average Annual Dividends between 1994 and 1999 = $ 532 million
– Dividends as % of FCFE = 96.2%
4. Aswath Damodaran 4
Con Ed: A Stable Growth DDM: December 31,
2000
n Earnings per share for trailing 4 quarters = $ 3.15
n Dividend Payout Ratio over the 4 quarters = 69.21%
n Dividends per share for last 4 quarters = $2.18
n Expected Growth Rate in Earnings and Dividends =3%
n Con Ed Beta = 0.80 (Bottom-up beta estimate)
n Cost of Equity = 5.1% + 0.80*4% = 8.30%
Value of Equity per Share = $2.18 *1.03 / (.083 -.03) = $ 42.37
The stock was trading at $ 38.60 on December 31, 2000
5. Aswath Damodaran 5
Con Ed: Break Even Growth Rates
Con Ed Value versus Growth Rate
$0.00
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
$70.00
$80.00
5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% -2.00% -3.00%
Expected Growth Rate
ValueperShare
Implied Growth Rate: Value per share = $ 38.60
6. Aswath Damodaran 6
Estimating Implied Growth Rate
n To estimate the implied growth rate in Con Ed’s current stock price,
we set the market price equal to the value, and solve for the growth
rate:
• Price per share = $ 38.60 = $2.18 *(1+g) / (.083 -g)
• Implied growth rate = 2.51%
n Given its retention ratio of 30.79% and its return on equity in 1999 of
10%, the fundamental growth rate for Con Ed is:
Fundamental growth rate = (.3079*.10) = 3.08%
7. Aswath Damodaran 7
Implied Growth Rates and Valuation
Judgments
n When you do any valuation, there are three possibilities. The first is
that you are right and the market is wrong. The second is that the
market is right and that you are wrong. The third is that you are both
wrong. In an efficient market, which is the most likely scenario?
n Assume that you invest in a misvalued firm, and that you are right and
the market is wrong. Will you definitely profit from your investment?
o Yes
o No
8. Aswath Damodaran 8
Con Ed: A Look Back
Con Ed: Valuations over Time
$-
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
1: December 1997 2: December 1998 3: June 1999
Date of Valuaton
PerShare
Estimated Value
Price per Share
9. Aswath Damodaran 9
ABN Amro: Rationale for 2-Stage DDM
n As a financial service institution, estimating FCFE or FCFF is very
difficult.
n The expected growth rate based upon the current return on equity of
15.56% and a retention ratio of 62.5% is 9.73%. This is higher than
what would be a stable growth rate (roughly 5% in Euros)
10. Aswath Damodaran 10
ABN Amro: Summarizing the Inputs
n Market Inputs
• Long Term Riskfree Rate (in Euros) = 5.02%
• Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)
n Current Earnings Per Share = 1.60 Eur; Current DPS = 0.60 Eur;
Variable High Growth Phase Stable Growth Phase
Length 5 years Forever after yr 5
Return on Equity 15.56% 15% (Industry average)
Payout Ratio 37.5% 66.67%
Retention Ratio 62.5% 33.33% (b=g/ROE)
Expected growth .1556*.625=.0973 5% (Assumed)
Beta 0.95 1.00
Cost of Equity 5.02%+0.95(4%) 5.02%+1.00(4%)
=8.82% =9.02%
11. Aswath Damodaran 11
ABN Amro: Valuation
Year EPS DPS PV of DPS
1 1.76 0.66 0.60
2 1.93 0.72 0.61
3 2.11 0.79 0.62
4 2.32 0.87 0.62
5 2.54 0.95 0.63
Expected EPS in year 6 = 2.54(1.05) = 2.67 Eur
Expected DPS in year 6 = 2.67*0.667=1.78 Eur
Terminal Price (in year 5) = 1.78/(.0902-.05) = 42.41 Eur
PV of Terminal Price = 42.41/(1.0882)5 = 27.79 Eur
Value Per Share = 0.60 + 0.61+0.62+0.62+0.63+27.79 = 30.87 Eur
The stock was trading at 24.33 Euros on December 31, 2000
12. Aswath Damodaran 12
Dividends
EPS = 1.60 Eur
* Payout Ratio 37.5%
DPS = 0.60 Eur
Expected Growth
62.5% *
15.56% = 9.73%
0.66 Eur 0.72 Eur 0.79 Eur 0.87 Eur 0.95 Eur
Forever
g =5%: ROE =15% (Ind. avg)
Beta = 1.00
Payout = (1- 5/15) = .667
Terminal Value= EPS6*Payout/(r-g)
= (2.67*.667)/(.0902-.05) = 42.41
.........
Cost of Equity
5.02% + 0.95 (4%) = 8.82%
Discount at Cost of Equity
Value of Equity per
share = 30.87 Eur
Riskfree Rate :
Long term bond rate in
the Netherlands
5.02% +
Beta
0.95 X
Risk Premium
4%
Average beta for European banks =
0.95 Mature Market
4%
Country Risk
0%
VALUING ABN AMRO
13. Aswath Damodaran 13
The Value of Growth
n In any valuation model, it is possible to extract the portion of the value
that can be attributed to growth, and to break this down further into
that portion attributable to “high growth” and the portion attributable
to “stable growth”. In the case of the 2-stage DDM, this can be
accomplished as follows:
Value of High Growth Value of Stable Assets in
Growth Place
DPSt = Expected dividends per share in year t
r = Cost of Equity
Pn = Price at the end of year n
gn = Growth rate forever after year n
P0 = DPS t
(1+r)t
∑
t=1
t=n
+ Pn
(1+r)n
-
DPS 0*(1+g n)
(r-gn)
+
DPS 0*(1+g n)
(r-gn)
- DPS 0
r + DPS 0
r
14. Aswath Damodaran 14
ABN Amro: Decomposing Value
n Value of Assets in Place = Current DPS/Cost of Equity
= 0.60 Eur/..0882
= 6.65 Eur
n Value of Stable Growth = 0.60 (1.05)/(.0882-.05) - 6.65 NG
= 9.02 Eur
n Value of High Growth = Total Value - (6.65+ 9.02)
= 30.87 - (6.65+9.02) = 15.20 Eur
15. Aswath Damodaran 15
S & P 500: Rationale for Use of Model
n While markets overall generally do not grow faster than the economies
in which they operate, there is reason to believe that the earnings at
U.S. companies (which have outpaced nominal GNP growth over the
last 5 years) will continue to do so in the next 5 years. The consensus
estimate of growth in earnings (from Zacks) is roughly 10% (with
bottom-up estimates) and 7.5% (with top-down estimates)
n Though it is possible to estimate FCFE for many of the firms in the
S&P 500, it is not feasible for several (financial service firms). The
dividends during the year should provide a reasonable (albeit
conservative) estimate of the cash flows to equity investors from
buying the index.
16. Aswath Damodaran 16
S &P 500: Inputs to the Model (12/31/00)
n General Inputs
• Long Term Government Bond Rate = 5.1%
• Risk Premium for U.S. Equities = 4%
• Current level of the Index = 1320
n Inputs for the Valuation
High Growth Phase Stable Growth Phase
Length 5 years Forever after year 5
Dividend Yield 1.25% 1.25%
Expected Growth 7.5% 5.5% (Nominal US g)
Beta 1.00 1.00
17. Aswath Damodaran 17
S & P 500: 2-Stage DDM Valuation
Cost of Equity = 5.1% + 1(4%) = 9.1%
Terminal Value = 23.69*1.055/(.091 -.055) = 691.55
$526.35Intrinsic Value of Index =
$462.73$15.55$15.78$16.02$16.26Present Value =
$691.55Expected Terminal Value=
$23.69$22.04$20.50$19.07$17.74Expected Dividends =
54321
18. Aswath Damodaran 18
Explaining the Difference
n The index is at 1320, while the model valuation comes in at 526. This
indicates that one or more of the following has to be true.
• The dividend discount model understates the value because dividends are
less than FCFE.
• The expected growth in earnings over the next 5 years will be much
higher than 7.5%.
• The risk premium used in the valuation (4%) is too high
• The market is overvalued.
19. Aswath Damodaran 19
A More Realistic Valuation of the Index
nThe median dividend/FCFE ratio for U.S. firms is about 50%. Thus the
FCFE yield for the S&P 500 should be around 2.5% (1.25%/.5).
nThe implied risk premium between 1960 and 1970, which was when
long term rates were as well behaved as they are today, is 3%.
nWith these inputs in the model:
1 2 3 4 5
Expected Dividends = $35.48 $38.14 $41.00 $44.07 $47.38
Expected Terminal Value = $1,915.07
Present Value = $32.82 $32.63 $32.45 $32.27 $1,329.44
Intrinsic Value of Index = $1,459.62
At a level of 1320, the market is undervalued by about 10%.